Since the Great Depression, the CPI has declined only twice–in 1949 and 1955. Those years turned out to be a treat. Prices dropped while wages rose, leaving workers better off. Investors, too, had no complaints. Stocks jumped 18.6 percent in ‘49 and 31.5 percent in ‘55. Not bad, for a phenomenon that’s so widely feared.
Bad name: How come deflation got such a bad name? “Solely because of what happened in the 1930s,” says economist George Selgin of the University of Georgia’s Terry College of Business. “In the late 1800s, people assumed that things would get a little cheaper every year, and they liked it that way.” Prices dropped gradually for a couple of decades, while business prospered. Wages stayed steady, so purchasing power actually rose.
The simple act of price-cutting happens all the time, with no ill effect on the economy as a whole. Sometimes cuts are driven by a jump in supplies, as when harvests are huge or more oil is pumped than the global economy needs. Sometimes they result from gains in productivity: producers find ways of making things at a lower cost. Last year we paid less, on average, for cars, gasoline, home furnishings and other consumer durable goods.
Cuts like these ring no alarm bells during inflationary times. Other prices rise and general inflation keeps going up, although at a slower pace. But with inflation nearing zero (just 1.7 percent in 1997), cuts could theoretically push the price level into minus territory. Ancient fears of depression are bubbling up. Is this the start of a spiral down?
No way, says economist Irwin Kellner of Kellner Economic Advisers in Port Washington, N.Y. Normal price-cutting doesn’t lead to dangerous business slumps. On the contrary, it’s expansionary, he says. Lower prices encourage people to shop. For deflation to turn dangerous, an obdurate Fed would have to run tight-money policies at a time when business was declining and people were being thrown out of work.
In the late 1920s the Fed deliberately tightened money to prick stock speculation and support the value of the dollar relative to gold, says economist Peter Temin, author of “Lessons From the Great Depression” and a professor at the Massachusetts Institute of Technology. Other industrial countries put similar deflationary policies into play. If they’d whacked their economies quickly and then lightened up, there would have been a normal recession, not a depression, Temin thinks. But everyone pulled on the reins too long. Businesses went into free fall, with each collapse breeding another one. The Fed won’t make that mistake again.
Earlier this month Fed chairman Alan Greenspan worried aloud about the risks in two kinds of deflation: (1) sudden asset deflation (in English, that’s a stock or real-estate crash), which could disrupt the economy, and (2) ongoing price deflation, which might scare consumers, dry up demand and make any downturn worse.
If conditions weakened so much that wages fell, there’d also be debt deflation, says economist Bradford De Long, a professor at the University of California, Berkeley. Borrowers wouldn’t be able to repay the loans they’d acquired in earlier days. Banks would drop like flies. That’s the stuff depressions are made of.
For these reasons and more, Greenspan’s Grail is price stability–a zero-inflation world, where people make plans without having to hedge against future price changes in either direction.
Good results: But I’ve come to praise deflation, not to bury it. When labor productivity rises–up 2.4 percent by the most recent count–prices can fall by the same amount, with benevolent effects. Under this scenario, wages would probably stay the same or rise a bit. But because things cost less, standards of living would improve. Borrowers could repay their debts. Even people on fixed incomes would get a break, because their dollars would go further.
If deflation arises from increased business efficiency, everyone should relax, Selgin says. The Fed shouldn’t fight it. Printing money might produce a bubble in stock prices that could end badly.
Under mild deflation, stock prices have historically done just fine, says Steve Leuthold of The Leuthold Group in Minneapolis. The record since 1872 is a surprising one.
The best environment for stocks turns out to be price stability or mini-inflation–price gains of 0.1 percent to 1 percent a year. We’ve had 12 of these lucky years. During them, stocks returned an annual average of 20.7 percent.
Stocks have also welcomed inflation of 2 percent to 3 percent. Such years (16 of them) produced a 17 percent average return.
We’ve had 24 years of modest deflation (mostly in the murky past), with consumer prices running at zero to minus 2.5 percent. During those periods, stocks averaged 13.8 percent.
Stocks have usually been trashed when mild deflation turns into something worse, especially when a recession is going on. Stocks also declined in the 16 years when inflation rose 7 percent or more. Markets like stability. They hate extremes.
Interest rates on corporate bonds have been lowest when prices rose or fell moderately, or leveled out. They’ve risen when inflation or deflation got out of hand. Why would rates rise when the price index tumbled? Probably because the economy got so poor that bonds were more likely to default, Leuthold says.
I’m touting mild deflation here. Price drops that exceed productivity gains could indeed cause wages to fall. But we’re a long way from that. For now, it’s OK for things to get cheaper. It brings back the good old days.
